Liability Management

3-6-3 Rule

• During 1960’s, banking in the USA was said to operate according to the 3-6-3 rule.

• Take deposits at 3%, make mortgage loans at 6%, and be on the golf course at 3 o’clock.

• Since then, increasing financial market technology and banking deregulation have led to a more complicated environment in terms of search for funds.

Students should be able to

• Identify different types of liabilities, their risk characteristics, and general trends.

• Calculate the historical and marginal cost of different sorts of funds.

• Calculate the weighted costs of funds.

• Source: Bank Management by Timothy W. Koch and Scott S. Macdonald.

Deposit Liabilities• Demand Deposit: Checking account services

that permit depositors to write drafts in payment that the bank must honor immediately upon presentation (UK: Current Account)

• Savings Deposit: Interest bearing funds left indefinitely with a bank with no minimum required maturity.

• Time Deposit: Interest bearing accounts with stated maturities which may carry penalties in the case of early withdrawal.

• Negotiable Certificate of Deposit: A type of interest bearing deposit that may be sold any number of times before maturity.

Trends in Demand Deposits in HK

History of Deposit Liabilities

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

Demand Deposits Savings Time Deposits NCDs

1980 1990 2005

Structure of LiabilitiesLiabilities Bank of East Asia 2004Deposits from Banks 5.39%Demand Deposits 6.72%Savings Deposits 27.46%Time Depocits 58.08%NCDs 2.35%

Maturity Structure of Time Deposits - Bank of East Asia 2004

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

Demand 3 Months 3Mo-1Year 1-5 Years

Banks can control the flow of deposits by offering only products with specific maturities and minimum balances and varying the relative rates paid according to these terms.

December 2005, HKSource:

Interest Cost of Funds

0

0.5

1

1.5

2

2.5

3

3.5

7 Days 1 Month 3 Months 6 Months

Savings

< 100K

> 100K

> 500K

Calculating the net cost of transaction accounts

• Annual historical net cost of bank liabilities is historical interest expense plus noninterest expense (net of noninterest income) divided by the investable amount of funds:

• A regular check account that does not pay interest, has $20.69 in transaction costs charges $7.75 in fees, an average balance of $5,515, 5% float would have a net cost of:

ratio) reserve required - (1x float of net Balance Average

Income tNoninteres - Expense tNoninteres Expense Interest

sLiabilitieBank of Cost Net

4.66%x120.90x 0.95 x. $5,515

$7.75-$20.69$0checking regular of cost net %

Required reserves on transactions account are 10%.

Historical Cost of Funds, terms.

• Required Reserve Ratio: Percentages applied to transactions accounts and time deposits to determine the dollar amount of required reserve assets, including vault cash and deposits at the central bank.

• Float: Dollar amount of checks in process of collection, net of deferred availability amouns, to depositors.

Demand Accounts Savings Accounts Time Deposits

Unit Cost

Monthly Income /

Expenses Unit Cost

Monthly Income /

Expenses Unit Cost

Monthly Income /

Expenses Income Interest Income (estimated 7.5% earnings credit) $ 29.47 $ 34.04 $ 121.84 Non-Interest Income Service Charges $ 2.80 $ 0.44 $ 0.11 Penalty Fees $ 4.32 $ 0.28 $ 0.27 Other $ 0.63 $ 0.16 $ 0.05 Total Non-Interest Income $ 7.75 $ 0.88 $ 0.42 Expenses Activity Charges Deposit - Electronic $ 0.0089 $ 0.02 $ 0.0502 $ 0.01 $ 0.1650 $ 0.1296 Deposit - Non Electronic $ 0.2219 $ 0.66 $ 0.7777 $ 0.46 $ 3.1425 $ 2.2016 Withdrawal - Electronic $ 0.1073 $ 0.43 $ 0.4284 $ 0.07 $ 0.5400 $ 0.2840 Withdrawal - Non Electronic $ 0.2188 $ 3.63 $ 0.7777 $ 0.39 $ 1.4933 $ 0.5875 Transit Check Deposited $ 0.1600 $ 1.71 $ 0.5686 $ 1.09 Transit Check Cashed $ 0.2562 $ 0.50 Account Opened $ 9.46 $ 0.20 $ 33.63 $ 0.53 $ 5.78 $ 1.73 Account Closed $ 5.67 $ 0.07 $ 20.18 $ 0.26 $ 3.38 $ 1.02 On-Us Checks Cashed $ 0.2412 $ 0.42 Account Maintenance (Truncated) monthly $ 2.42 $ 1.67 $ 4.10 $ 3.56 $ 1.99 $ 1.99 Account Maintenance (Non truncated) monthly $ 8.60 $ 7.03 Official check issued $ 1.02 Total Activity Expense $ 16.34 $ 6.37 $ 7.94 Net Indirect Expense $ 4.35 $ 1.81 $ 18.38 Total Non-Interest Expense $ 20.69 $ 8.18 $ 26.32 Interest Expense 1.25% $ 5.38 2.96% $ 13.45 5.18% $ 69.79 Total Expense $ 26.07 $ 21.63 $ 96.11 Net Income (expense) Before Earnings Credit $ (18.32) $ (20.75) $ (95.69) Net Revenue Per Month $ 11.15 $ 13.29 $ 26.16 Average Account Balance $5,515.00 $5,557.00 $19,495.00 Average Annual Net Costa 4.66% 4.57% 5.89% Average Interest Cost 1.37% 2.96% 4.30% Average Non-interest Cost 5.27% 1.80% 1.62% Average Non-interest Income 1.97% 0.19% 0.03% a Required reserves are assumed to be 10 percent for demand accounts and zero for others. Float is assumed to be 5

percent for demand accounts, 2 percent for savings accounts and zero for time accounts. Source: Functional Cost and Profit Analysis, Based on data furnished by participating banks in twelve Federal Reserve Districts, 1999 National Average Report,

Time Deposits

• During the 1980’s, Time deposits became the dominant source of funding for HK banks.

• Time deposits have higher interest rate costs but lower transactions costs.

• Time deposits are often volatile liabilities i.e. large investments made by depositors who are intensively sensitive to interest rates and risk.

Time deposits and …

• Interest Rate Risk Time deposits more interest sensitive than core deposits. Must be repriced rapidly when rates change.

• Liquidity Risk Reliance on volatile deposits makes it easy to have a liquidity shortfall.

• Credit Risk Vicious cycle. Banks may try to acquire high risk/return assets to pay high deposit costs. Higher credit risk may cause interest costs to rise.

Historical Cost vs. Marginal Cost• To consider whether it is profitable to make an additional

loan, bank should compare marginal cost with marginal revenue from source of loans.

• Marginal cost of debt…a measure of the borrowing cost paid to acquire one additional unit of investable funds

• Marginal cost of equity capital…a measure of the minimum acceptable rate of return required by shareholders.

• Together, the marginal costs of debt and equity constitute the marginal cost of funds, which can be viewed as independent sources or as a pool of funds.

Costs of independent sources of funds

• Marginal costs include both the interest

and noninterest costs it expects to pay and

identify which portion of the acquired funds

can be invested in earning assets.

• Conceptually, marginal costs may be

defined as :

Marginal Cost

Interest Rate + Servicing costs + Acquisition costs

1 - % of funds in nonearning assets

Example:Marginal costs of a hypothetical

saving account• Assume:

– market interest rate = 1.9%

– servicing costs = 4.1%

– acquisition costs = 1.0% of balances

– percentage in nonearning assets = 2.0% (2% held in reserves)

• The estimated marginal cost is 7.14%:

0.019 0.041 0.01

marginal cost 0.07140.98

WMC is computed in three stages. 1. Forecasts shares of financing from equity and different

kinds of deposits and debt. (wj)

2. Estimate the marginal cost of each independent source of funds. (kj)

3. Combine the individual estimates to project the weighted cost, which equals the weighted sum of the component costs across all sources.

• Each source’s weight (wj) equals the expected dollar amount of financing from that source divided by the dollar amount of total liabilities and equity and kj equals the single-source j component cost of financing:

m

1jjjkwWMC

(WMC) …the best cost measure for total assets is a weighted marginal cost of funds

• This measure recognizes both explicit and implicit costs associated with any single source of funds.

• It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds.

Calculate the cost of subordinated debt

• Assume the bank will issue:– $10 million in par value subordinated notes– paying $700,000 in annual interest and – carrying a 7-year maturity. – It must pay $100,000 in flotation costs to an

underwriter.

• The effective cost of borrowing (kd), where t equals the time period for each cash flow, is 7.19%:

7.19% k or

)k(10$10,000,00

)k(1$700,000

$9,900,000

d

7d

7

1tt

d

Calculating Yield to Maturity

Borrower Coupon Frequency Maturity k (Yield to Maturity)HK Prop 5.28 Q 20-07-09 4.76%SHK Prop 5.75 Q 18-07-12 4.90%HK SAR 3.75 S 23-07-09 4.26%HK SAR 5.13 S 23-07-19 4.74%

• YIELD• See Also• Returns the yield on a security that pays periodic interest. Use YIELD to calculate bond yield.• If this function is not available, and returns the #NAME? error, install and load the Analysis ToolPak add-in.• How?• On the Tools menu, click Add-Ins. • In the Add-Ins available list, select the Analysis ToolPak box, and then click OK. • If necessary, follow the instructions in the setup program. • Syntax• YIELD(settlement,maturity,rate,pr,redemption,frequency,basis)• Important   Dates should be entered by using the DATE function, or as results of other formulas or functions. For

example, use DATE(2008,5,23) for the 23rd day of May, 2008. Problems can occur if dates are entered as text.• Settlement   is the security's settlement date. The security settlement date is the date after the issue date when the

security is traded to the buyer.• Maturity   is the security's maturity date. The maturity date is the date when the security expires.• Rate   is the security's annual coupon rate.• Pr   is the security's price per $100 face value.• Redemption   is the security's redemption value per $100 face value.• Frequency   is the number of coupon payments per year. For annual payments, frequency = 1; for semiannual,

frequency = 2; for quarterly, frequency = 4.

Targeted return on equity model …investors require higher pretax returns on common stock than on debt issues because of the greater assumed credit

risk.

• Many banks use a targeted return on equity guideline based on the cost of debt plus a premium to evaluate the cost of equity.

Equity rsStockholde

taxes before income Targetedreturn required Pretax

Since 2003, HKMA constructs a composite interest rate for use as a base rate

Dec-2003 Mar-2004 Jun-2004 Sep-2004 Dec-2004 Mar-2005 Jun-2005 Sep-2005

2.4

2.2

2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

HK: Composite Interest Rate% pa

Interbank Market:USA

• Federal funds are reserve balances at US Federal Reserve Banks that depository institutions can lend to one another.

• The most common federal funds transaction is an overnight, unsecured loan between two financial institutions.

• Hong Kong InterBank Offered Rate: The rate on which one bank deposits money at another reason for short-term lending.

Dec-1984 Dec-1987 Dec-1990 Dec-1993 Dec-1996 Dec-1999 Dec-2002 Dec-2005

16

14

12

10

8

6

4

2

0

HK: Interbank Offered Rate: 3 Month% pa

Deposit Protection Scheme

• Hong Kong will implement a scheme of insurance for bank deposits less than HK$100K.

• Banks pay some insurance fee and if the bank goes bankrupt, the bank regulator pays depositors up to some limit.

• Only protects very small depositors, up to 84% of deposits by value are in accounts in excess of $100K

Loan PricingPrice Leadership Model

Loan Interest

Rate=

Base or Prime Rate

+

Default Risk

Premium for Non-

Prime Borrowers

+

Term Risk Premium for

Longer Term Credit

Loan Interest

Rate=

Marginal Cost of Raising

Loanable Funds to Lend to

Borrower

+

Nonfund Bank

Operating Costs

+

Bank's Desired Profit

Margin

Below Prime Pricing• Traditionally, prime rate is rate offered to a

bank’s best commercial borrowers.• Recently, banks have been lending at rates

below their posted prime interest rate. Bank of America Lending Rates Hong Kong

0

1

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5

6

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8

9

5/21

/200

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8/21

/200

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11/2

1/20

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2/21

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5/21

/200

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8/21

/200

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2/21

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5/21

/200

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8/21

/200

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11/2

1/20

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2/21

/200

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5/21

/200

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8/21

/200

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11/2

1/20

04

2/21

/200

5

5/21

/200

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8/21

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11/2

1/20

05

Best Lending Rate Mortgage Rate